Public Policy Analysis & Opinion

Potomac fever

Scrutinizing GAO and FTC reports for harbingers of change

By Kevin P. Hennosy

Federal officials began 2009 by initiating an aggressive posture toward the business of insurance and its regulation by the states. The Government Accountability Office (GAO), an investigative arm of Congress, has issued a report on financial regulation in the United States, which is critical of the current framework. In addition, the Federal Trade Commission (FTC) launched an investigation of credit-based underwriting and pricing (CBUP) in homeowners insurance. This level of federal interest in insurance and its regulation has been sorely lacking since the mid-1990s.

The GAO

The tone and tenor of the GAO report is made clear in one sentence: “The current U.S. financial regulatory system has relied on a fragmented and complex arrangement of federal and state regulators—put into place over the past 150 years—that has not kept pace with major developments in financial markets and products in recent decades.”

The investigators called for a new approach to financial regulation which is integrated, uniform with and attuned to “systemic risk,” which is “the risk that an event could broadly effect [sic] the financial system rather than just one or a few institutions.”

This approach would reject the principle of “functional regulation,” which was established by the Gramm-Leach-Bliley Act of 1999. Under functional regulation, one institution that engages in multiple kinds of financial services was subject to the oversight of numerous regulatory agencies based on “function.”

The report elicited a series of comments from stakeholders in the current debate over insurance public policy.

New Hampshire Insurance Commissioner Roger Sevigny, who was elected president of the National Association of Insurance Commissioners (NAIC) in December 2008, criticized the GAO for overreaching.

“While the GAO report does not take a position on the proposed optional federal charter for insurance regulation, state insurance regulators recognize that such a proposal would only increase the complexity of the current U.S. financial regulatory structure and not address the gaps in regulation or inadequate coordination and communication between functional regulators,” Commissioner Sevigny said.

Furthermore, Commissioner Sevigny expressed his concern over congressional action: “We caution Congress against efforts by some in the industry to use the current financial turmoil as a pretext for proposing changes to the existing state regulatory structure that would essentially result in deregulation.”

The American Council of Life Insurers (ACLI), a proponent of optional federal charter legislation, released the following assessment of the GAO report: “ACLI appreciates GAO’s recommendation that Congress consider creation of an optional federal charter for insurance regulation as part of a broader examination of financial regulatory reform in the United States. We look forward to the inquiry and will fully present our perspective during the congressional hearings.”

On the property/casualty side of the business, the American Insurance Association (AIA) issued a comment under the signature of the trade association’s new president, Leigh Ann Pusey.

“It’s clear that the current 56-jurisdiction patchwork of insurance regulation is outdated and limited. Having insurance regulation at the federal level would provide the national framework to effectively monitor the safety and soundness of nationally chartered insurers to the benefit of U.S. businesses and individuals that rely on those institutions. It is important, however, that federal insurance regulation is flexible and responsive to consumer demands in a dynamic marketplace, not duplicative or bifurcated.

“Clearly, this modernized regulatory structure is necessary in today’s complex and interconnected financial world and global economy.”

Those groups that seek to use the GAO report to jumpstart an old Optional Federal Charter (OFC) proposal that would exempt insurers from state regulation without applying a material system of federal oversight by claiming that the report endorses the proposal are overstating the GAO’s position.

“Despite some assertions to the contrary, the GAO does not formally recommend that an [OFC] be debated,” added Charles Symington, senior vice president of government affairs for the Independent Insurance Agents & Brokers of America. “The study only mentions OFC in passing and that an OFC regime could be considered by Congress.”

Jimi Grande, vice president for federal and political affairs at the National Association of Mutual Insurance Companies (NAMIC), struck a more balanced tone when assessing the GAO report:

“This report clearly indicates the need for better regulation and coordination of those sectors responsible for the economic turmoil,” Grande said. “The fact that the authors did not consider proposals to federally regulate the property/casualty insurance industry only emphasizes the fact that the state-based solvency regulation of the P-C industry has proven effective and sets the industry apart in continuing to protect the needs of policyholders.”

From the perspective of insurance consumers and producers in the field, the GAO report recommends a troubling change in the philosophical tenets of state insurance regulation. The GAO recommends placing equal treatment on the interests of policyholders and investors. This runs counter to a bedrock Supreme Court decision that directs insurance regulators to focus on the policyholder, without concern for the shareholders of insurance companies.

Part of the problem is that for the last quarter century, state-based groups like the NAIC have misstated the true purpose of insurance regulation in an attempt to curry favor with the insurance carrier trade associations. The GAO report opines that, “State insurance regulators focus on the ability of insurance firms to meet their commitments to the insured.” While this statement might be an accurate description of the performance of state insurance regulators, it does not describe the charge given to the states by the McCarran-Ferguson Act.

The U.S. Supreme Court clarified the scope and focus of insurance regulation in SEC v. National Securities, Inc., 393 U.S. 453 (1969). In that case, the Court overturned a merger approved by the Arizona Department of Insurance because the approval was granted “in the interest of shareholders.” Furthermore, the Court ruled that the McCarran-Ferguson Act required the states to regulate “[t]he relationship between insurer and insured, the type of policy which could be issued, its reliability, interpretation, and enforcement—these were the core of the ‘business of insurance.’”

The GAO and members of Congress should study this case before moving forward in the policymaking process.

The FTC

In December 2008, The Federal Trade Commission (FTC) requested data related to the Credit-Based Underwriting and Pricing (CBUP) for homeowners insurance.

State Farm Mutual Automobile Insurance Company, The Allstate Corporation, Fire Insurance Exchange, Nationwide Mutual Insurance Company, The Travelers Companies, Inc., United Services Automobile Association, Liberty Mutual Holding Company, Inc., The Chubb Corporation, and American Family Mutual Insurance Company received the FTC “request”—which is somewhat akin to receiving “Greetings” from the President of the United States through the Selective Service System.

Flawed auto study

It will be interesting to note whether or not the FTC under a new administration and a grumpy Congress will take a more aggressive approach in conducting this report than it did in 2007, when the commission issued a report on CBUP in auto insurance. Outside of a few press releases issued by insurance carrier trade groups, the CBUP auto insurance report was roundly criticized for slanted and sloppy analysis.

When the FTC published the 2007 report, several insurance trade associations trumpeted the findings as proof that the CBUP is a superior predictor of the frequency and severity of future claims. One might even use the term “slam dunk” to describe the FTC findings in support of the statistical, moral and ethical purity of CBUP, if one was bound and determined to see the use of CBUP.

Of course, as Mark Twain once observed, “There are lies, damn lies and there are statistics.” The FTC report is based on a database created from a highly dubious data set. The most disconcerting flaw in the auto insurance study was that the FTC did not deconstruct the credit ratings upon which the CBUP is based.

The FTC based its study on a database constructed from policy, pricing and claims data. The analysts did not look into how the “insurance scores” that drive the CBUP are created by the major credit agencies in cooperation with the insurers that purchase the scores.

Even in states where legislatures have “banned” the use of CBUP as the “sole” deciding factor in underwriting and pricing, insurance scores now drive the availability and affordability of auto and homeowners insurance products. Nevertheless, the FTC did not investigate how the credit rating agencies create the insurance scores that form the foundation of CBUP. In writing the report, the FTC ignored the elements and presumptions that form the foundation of credit scoring.

The devil is in the details, and the FTC used data from points in the process well after Old Scratch had practiced his Dark Arts.

When one reads the FTC report on CBUP in auto insurance, it becomes clear that there must have been significant discord among the commission staff charged with writing the paper. One can easily envision a conference room somewhere in the FTC headquarters where staff members gathered to hammer out what was “in and out” of the final report with political hires lining up against career analysts as each paragraph being subject to rhetorical combat. The logical progression of the text went by the wayside.

Even in the Executive Summary of the report, the staff findings were presented in a manner that can best be described as a rhetorical seesaw.

For example, the FTC found that, “Credit-based insurance scores are effective predictors of risk under automobile policies. They are predictive of the number of claims consumers file and the total cost of those claims.”

But in the next paragraph, the report acknowledges a correlation between credit ratings and claims, but the FTC analysts had no idea whether there was a causal relationship between one’s credit rating and the risk of financial loss from a covered risk or peril. What they verify is a correlation and not a cause. “Several alternative explanations for the source of the correlation between credit-based insurance scores and risk have been suggested. At this time, there is not sufficient evidence to judge which of these explanations, if any, is correct.”

The report notes, “With the use of scores for consumers whose information was included in the FTC’s database, the average predicted risk (as measured by the total cost of claims filed) for African Americans and Hispanics increased by 10% and 4.2%, respectively, while the average predicted risk for non-Hispanic whites and Asians decreased by 1.6% and 4.9%, respectively.”

And yet, in apparent disregard for the statistical differences noted above, in the very next paragraph the report writers admonished, “Credit-based insurance scores appear to have little effect as a ‘proxy’ for membership in racial and ethnic groups in decisions related to insurance.”

Which is it, people? If the FTC can identify statistical trends in the data that are clearly attributable to specific racial and ethnic groups, so can insurance carriers.

In addition to the contradictory rhetoric found in the report, the reader is subjected to little gems that demonstrate that the FTC’s analysis was something out of The Twilight Zone.

Submitted for your approval is the following observation from page seven of the report: “Consumers purchase insurance to protect themselves against the risk of suffering losses.”

While one expects to find that kind of statement in a text marketed to high schools for use in business classes, the FTC is charged with policing markets for violations of free and fair competition. Since large sectors of the auto insurance consumers may buy a policy only because they are compelled to by state law or contractual agreement with a lien-holder, it is more than a bit of Pollyanna to make the pacific state-of-nature assumptions put forward by the FTC report.

A dissenting opinion

The noticeably slip-shod nature of the FTC’s report on CBUP in auto insurance even led a member of the commission to issue her own statement of dissent with the report’s findings. Commissioner Pamela Jones Harbor observed: “I respectfully dissent from this report for several reasons:

• I disagree with the methodology used to generate the report. The data collection and analysis fell short of the Commission’s gold standard for rigor and completeness, and did not reflect the agency’s best practices. Better alternatives were available and should have been utilized.

• Because I distrust the integrity of the underlying data set upon which the study was based, I also doubt the reliability of any conclusions the report might draw.

• For these and other reasons, the report, with improved methodology, could have more aptly addressed Congress’s questions.”

The commissioner’s statement reminded the commission of its broad powers to secure the data that it needs to produce the “gold-standard of rigor and completeness” that represents the agency’s best practices. “In particular, Section 6(b) of the Federal Trade Commission Act broadly empowers the Commission to issue orders to compel, under oath, ‘reports or answers in writing to specific questions, furnishing to the Commission such information as it may require….’”

There is no practical reason related to authority or resources that would have precluded the FTC from garnering the data elements to do the job right. Commissioner Harbor was gracious to state that she did not question the good faith of the commission staff or her fellow commissioners; however, the commission’s shoddy analysis and the report’s findings gave this reader the distinct impression that “the fix was in.”

The author
Kevin P. Hennosy specializes in the history and politics of insurance regulation. He served as public affairs manager for the National Association of Insurance Commissioners (NAIC). Since leaving the NAIC staff, he has written extensively on insurance regulation and testified before the NAIC as a consumer advocate.